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What is an ETF? Understanding The Difference Between a Mutual Fund

There has been plenty of hype and discussion, in the recent past, with respect to exchange-traded funds (ETFs) as a novel, and enhanced means of investing. Actually, these funds are not very different when compared to more conventional mutual funds. Similar to mutual funds, they assist investors by pooling together their money to purchase a well diversified portfolio which comprises bonds or stocks or a combination of both. However, the only significant difference is that you do not purchase an ETF from a fund company directly and instead you purchase a portion or share of it via a broker, just like in the case of a stock.

Definition of ETF

An ETF can be defined as any marketable security that mimics or tracks an index, bonds, a commodity or a basket of disparate assets such as an index fund. In contrast to mutual funds, an ETF trades on the market (like NYSE, DJI) like a common stock on stock exchanges. ETFs undergo price fluctuations throughout the entire trading day as they are sold and bought on a frequent basis. Therefore, these funds usually have more daily liquidity and lower expenses and fees compared to shares of mutual funds, which makes them an attractive and lucrative alternative for many investors.

The structure of the actual investment vehicle (like an investment trust or a corporation) will differ from country to country, and within a single country multiple structures may co-exist simultaneously.

Vicarious Ownership

ETF is a special and unique kind of fund that has ownership in the underlying securities or assets (bonds, shares of company stock, gold bars, oil futures and foreign currency) and splits this ownership stake in those assets in shares. It is important to keep in mind that as an ETF tends to trade like a stock, its net asset value (NAV) need not be calculated on a daily basis at the end of each trading day like a mutual fund does.

Shareholders of an ETF don’t have direct ownership or claim a stake in the underlying investment securities or assets that make up the fund; instead they own these underlying assets indirectly.

Investors in ETF have the right to their proportion of earning or profit, in the form of dividends or interest income, and they are also entitled to residual values of assets if their fund liquidates. Investors can easily purchase, sell and transfer an ownership stake in the fund, just like in the case of shares of company stocks, because shares of ETF are publicly traded on most stock exchanges in the world.

Passive Management and Costs

A majority of ETFs are index based funds, which means that they do not have managers who specially and actively decide which investments to purchase, hold, and dispose off; rather they passively emulate or replicate a bunch of investments. For instance, SPDR of State Street which trades on S&P 500 replicates the well-established index of certain blue-chip US stocks. Vanguard Small-Cap mimics an index which is composed of small companies, while BlackRock’s iShares has a representative holding slice of foreign (non-US) stocks.

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Similar to index based mutual funds, ETFs tend to have insignificant expenses or costs. Actually, their yearly expenses are typically lower when compared to a mutual fund which tracks the exact same index.

However, as an investor you may end up losing some of that price advantage due to higher trading costs. As you need to purchase ETFs through a broker rather than directly from the relevant fund company, you will have to pay a commission every time you sell or purchase shares in an ETF. (However, numerous brokers are now offering free trades on a selected few ETFs.)

Eventually, it all boils down to a choice between an index based mutual fund or an ETF which is mainly a matter of convenience for most investors. In case you do not have a brokerage account already, making an investment in a regular and conventional mutual fund is much simpler. On the other hand, if you have a brokerage account, an ETF gives you instant access to purchase an index with just a click of your mouse.

Popular ETFs and Companies

These are some of the most popular and largest (in terms of assets under management) ETFs that are trading on the market:

Difference between an ETF and Index Mutual Fund

There is an important distinction between an ETF and an index based mutual fund. There is a plethora of ETFs, which are tracking an increasingly broad and huge variety of indices. An investor can purchase ETFs simply by strictly following bank stocks, or stocks of companies which operate in the alternative energy segment, or Chinese stocks. In contrast to well-diversified and broad index ETFs, hyper-focused funds of these types can’t be an investor’s core investments. This is because they are more akin to dealing in individual stocks.

There are also a number of ETFs that use a set of alternate rules for index construction. While traditional indices weigh their holdings in stock on the basis of their market worth, a slew of more recent ETFs follow indices that are tilted in a way that tends to favor various variables the designer of the index contends will provide investors an opportunity to make higher returns. For instance, there are a few ETFs which are tilted in favor of stocks which yield higher dividends while others tend to invest a little more in companies which have higher revenue streams.

Although both funds that are discussed above are index funds in strictly technical terms, these ETFs usually blur the fine line between active and passive management. If an investor purchases one, he or she might or might not perform well financially, but in this case you certainly can’t rely on earning the average return of the market.

Creation and Redemption of ETFs

Supply of ETF stock is usually regulated via a mechanism which is called redemption and creation. This mechanism involves a number of large and specialized investors, who are called authorized participants . These APs are generally massive financial institutions, like investment banks or market makers who might be investment companies or banks, who wield a great degree of buying strength. Only APs have the ability to redeem or create shares or units of ETFs.

When the creation process is initiated, an AP puts together the requisite portfolio of underlying securities or assets and transfers that basket of assets to the relevant funds in exchange for new ETF shares. For redemptions, the process is similar which involves APs returning shares of ETF to the relevant fund and receiving the basket which consists of the asset which underlie the portfolio. The underlying holdings of the fund are revealed to the public on a daily basis.

Traders and ETFs

As both an ETF and its basket of assets can be traded throughout the trading day, traders make the most of momentary opportunities for earning arbitrage gains, which keep the ETF value pretty close it its market worth. If a broker has the chance of buying an ETF for lower than the price of underlying assets, they will generally purchase the ETF’s shares and dispose of the underlying asset portfolio, which enables them to lock in the difference.

Few ETFs make use of leverage or gearing, they use a host of various derivative and similar products to develop leveraged or inverse ETF. Inverse ETFs are designed in a way that tracks the opposite yield of that of the securities or assets that underlie the portfolio. For instance, inverse silver ETF would benefit 2% for every 2% decline in the worth of silver. On the other hand, leveraged ETFs aim to score a multiple yield compared to that of the asset which underlies the portfolio.

Advantages of ETFs

When you own an ETF, you get to benefit from the diversification that the index fund offers along with the unique ability to buy on margins, sell short, and buy as low as a single share (these funds have no mandatory minimum deposits).ETFs also have expense ratios which are lower compared to those that are charged on a typical mutual fund. At the time of selling and buying ETFs, you are required to pay the exact amount of commission to your dealer as you will pay on a conventional stock order.

There is also a potential for more favorable taxation on the cash flows that are generated by an ETF, because capital gains on sales within the fund are not passed on to the shareholders as is the case with most mutual funds.

Disadvantages of ETFs

In a few countries, investors may be restricted to large-cap stocks only because of a narrow set of stocks that is available in the market index. The inclusion of larger stocks generally restricts the available exposure to small and mid cap companies. This seriously restricts the potential growth opportunities for ETF investors.

Moreover, long-term investors usually have a time horizon of 12 to 15 years, so they will usually not benefit from any intraday pricing fluctuations and swings. A few investors may end up trading more because of these lagged fluctuations in hourly prices.

With the emergence of more niche ETFs you might invest in a low volume index. This could raise your bid/ask spread. In these circumstances, you may get a better price by investing in the actual stocks or maybe even in a managed fund.

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